Offtakes and Stockpiles

The missing pieces for dealing with China and building capacity

Last week an article in the Financial Times reported that the United States is looking at creating a Sovereign Wealth Fund. A not insignificant part of the economic commentariat has not taken to this well and for fairly simple reasons: the US private sector is good at investing and the normal reason to establish a sovereign wealth fund - the combined resource curse and dutch disease, and efforts to avoid it - is not an issue when your country has a vibrant and highly diversified and complex economy. In addition the United States does have a number of very successful tech investing programs including DARPA, its spinoff ARPA-E and IN Q TEL. This is all very preliminary and unofficial - it is the FT and not a press release or policy statement - but there was a hint in the article about what might be included here that I consider very important: counter-cylical measures against Chinese dumping in the form of assistance and stabilization via stockpiling:

The official said the investments could be deployed to shore up the resilience of supply chains and finance “illiquid but solvent companies that need greater scale to compete against [People’s Republic of China] rivals”.  

Another use could involve funding the creation of “synthetic reserves of critical minerals”, the official said.

This has been discussed at length in the lithium and critical minerals series I wrote with Arnab Datta at Employ America, and in Arnab’s piece with Daleep Singh in the Financial Times. 

The Economic Problem

China has a tendency to overproduce and dump in strategic sectors. Whether in metals, solar panels or autos and batteries there is a consistent pattern in China prioritizing a sector leading to excessive capacity expansion and dumping abroad. The dumping is as much a result of soft credit constraints in the banking sector whereby banks will lend into businesses with terrible and deteriorating margins because that sector is either a politically powerful SOE or the sector is favored by national level policy. Victor Shih, Michael Pettis and Brad Setser have been on this beat for well over a decade and nothing appears to be changing on the China side. More booms and busts in policy sectors, more non-performing loans and bigger current account surpluses are likely to continue if there is no response. 

The Security Problem

A more concerning development is that once China develops a dominant position in production it frequently uses it to political ends via trade policy. A common strategy here is to ban exports of upstream commodities which they produced at a loss for years in turn killing off ex China competition then using export bans to consolidate the downstream within China. The CSIS series on Gallium is an excellent history of how this happened in Gallium:  

This leading position [in aluminum] has allowed China to establish a dominant share of global gallium production. Deliberate government policies also played a role, with Beijing requiring its booming aluminum producers to install the capacity to extract gallium. From 2005 to 2015 alone, China’s production of low-purity gallium exploded from 22 metric tons to 444 metric tons.

China’s rapid rise in the industry created oversupply in the global market, triggering severe fluctuations in gallium prices throughout much of the 2010s. Leading suppliers in the United Kingdom, Germany, Hungary, and Kazakhstan suffered as a result and were forced to shutter their production, leaving China as virtually the only supplier in the world.

Gallium goes into wide bandgap semiconductors and particularly high-power radio frequency applications (F-35 radars) and anything in power electronics from high wattage phone chargers to EVs. China’s export ban is now driving prices up in a manner similar to what happened when China also flexed its capacity in rare earth metals in the early 2010s. This strategy of developing dominance then using it for broader nationalistic objectives should be familiar to any European who has paid a gas heating bill in the last few years.

The Rare Earth Minerals Wars

After ramping prices up with export controls China then dumped prices to discourage new entrants leading to some spectacular impairments for private sector investors in resources. China almost succeeded in killing all new entrants and were it not for the efforts of JOGMEC, an arm of the Japanese government and a few creditors, an Australian producer and the only operational producer ex China called Lynas would likely have fallen into Chinese hands. Lynas’ equity returns over this period have been poor (LYC AU in white in the chart below) because the commodity has been alternately dumped and restricted (Neodymium-Praseodymium oxide, a rare earth input for high power magnets) which makes for extremely dilutive and inefficient growth in resources. Developing secure supply chains has been a largely thankless task which makes private capital somewhat ill fit to solve these problems because in a head-to-head with the Chinese state and its capacity to crash prices the private sector loses as the biggest most performance insensitive balance sheet wins.

Are We in a Battery Metal War Now?

There are many people who now think China is doing this in battery metals and solar and given the recent financial results for upstream listed companies in those sectors in China （-78% gross margins on polysilicon for one company) and their eye watering losses I am inclined to agree with them (edit: so are the companies themselves at least in solar according to this piece from Caixin out today). China is not the lowest cost player in lithium in particular and running capacity with cash costs in the $17,000-$20,000 per tonne of LCE equivalent when spot is $12,000 is highly suspect. I regret to say I have seen this show before and barring some government action it is unlikely to end well for equity holders. Unless governments outside China are willing to lend into losses like Chinese banks then a different set of tools will be required. 

Trade Protection Alone is Not the Answer

The obvious one is trade protection including tariffs. If a country restricts something being dumped to support the local supply chain that can be very effective in allowing domestic supply to develop. However there are acute problems with this that are emerging today. Tariffs need to be durable and credible and for that there needs to be some political consensus on them and a belief or confidence that the costs of the tariff will be manageable or negligible over time. The longer term cost of tariffs largely depends on how quickly domestic output can be ramped up and what that domestic output costs.These costs may be small and transient for some goods but in many of the capital intensive sectors that China engages in dumping that capacity takes time. Similarly, political consensus or a perceived lack thereof around certain sectors can lead private capital to hold back depending on the political cycle. US solar modules currently cost ~$0.30 per Watt due to tariffs and cost ~$0.085c per Watt elsewhere due to Chinese dumping and yet numerous US capacity expansions are being deferred until policy clarity after the election. This is imposing a cost on US consumers in the interim as a fair “cost plus a passable return” price in the US would be $0.12 to $0.15 per Watt as I argued here.

Smoothed Price and Production Paths 

Offtakes and stockpiling can be used together to smooth this path to building domestic capacity and pushing back against dumping while having minimized inflationary impacts. By providing some degree of security for investors and lenders as domestic output is ramped via fixed prices or collars the state can reduce the risk and cost of capital of building that out in a manner that provides security and predictability outside of a political cycle. This in turn can minimize transitional costs of protection provided the domestic industry is long term viable and competitive. In the case of the solar supply chain the US could provide a guarantee on a net basis including all subsidies such that any IRA roll back would be baked into the fixed or protected price period so that capacity gets built. In the case of metals like Gallium the US could provide similar price protection to get projects up and running and then use a strategic reserve to moderate price fluctuations and inflation going forward. These sectors would become less volatile, cheaper to finance and that would result in better value for consumers just as auctions for renewable capacity drove down the cost of wind and solar power. 

Making Bad Trade Conduct Fail

These measures would make China’s playbook of dumping and dominating upstream to consolidate and provide political leverage wholly ineffective at least for the United States. As seemingly uneconomic as China’s state and banking system nexus can be if they cannot ultimately dominate a sector in the long run by running spectacular losses in the short run then they are unlikely to try. This has important implications for global rebalancing: China responds to and respects little else but hard power both economically and militarily and by securing its supply chains the US will maintain the latter while also showing its steel in the former. It might even inspire similar measures from Europe which to date seems to be slow to grasp the magnitude of the dangers and challenges they face. If there is anything that could lead China to rethink its broader economic practices it is far more likely to be this than pleading requests and shuttle diplomacy.